Problems with Economic Transformation in Ukraine

Economic transformation in the former Soviet Union has been arduous with substantial declines in output and welfare. Even in this unfortunate lot, Ukraine stands out as one of the least successful countries in its attempts to become a productive market economy. The purpose of this paper is to try to determine why Ukraine has not been more auspicious in its attempts at economic reform.

Economic transformation in the former Soviet Union has been arduous with substantial declines in output and welfare. Even in this unfortunate lot, Ukraine stands out as one of the least successful countries in its attempts to become a productive market economy. The purpose of this paper is to try to determine why Ukraine has not been more auspicious in its attempts at economic reform.

To clarify Ukraine's position, we first need to look into how Ukraine has fared in comparison with other countries. Considering its preconditions, the most relevant comparison is with other post-Soviet countries, because all these countries had far worse preconditions than those in East-Central Europe. Therefore, we shall examine some major parameters of economic performance. Next, we shall explore why Ukraine went wrong initially. The curious thing about Ukraine, however, is that it does not seem to have moved out of the trap in which it got stuck initially. A plausible explanation is the power structure that has arisen, which will be described and then formalized as a four-sector model.

Our prime concern is how Ukraine possibly can get out of the doldrums. A natural start is an examination of what has not worked in Ukraine. However, quite a lot has actually worked, and that is the theme of the next section. With these perspectives, we shall move on to the question what might work that has not really been tried. While many of the necessary economic measures are obvious, the key issue is how they can be introduced and implemented politically.

For anybody who has followed the Ukrainian economic reforms, it is evident that the problems of the economic reforms are not in their details or even in their overall design. The problem is rather the politics of economic reforms. Either the political will or the political ability have fallen short. Yet, the political forces are dependent on economic conditions as well. If you start on one track, there are natural next steps to take, and it is difficult to change track altogether. The evolution of economic reforms becomes path-dependent.

The key economic indicator is of course gross domestic product. Ukraine has registered officially a total decline of about 53 percent from 1989 to 1998. By 1997, no less than seven post-Soviet countries had recorded greater declines, so that does not appear all too disturbing in a comparative context (ECE, 1998, p. 165). A greater worry, however, is that Ukraine has not had a single year of growth but a significant decline in GDP has continued every single year. Ukraine is the only country with such a poor performance. Nor is Ukraine likely to turn to growth soon. The International Center for Policy Studies in Kyiv forecasts a continued decline in GDP in both 1999 and 2000 (ICPS, 1999). Russia, Moldova and Kazakhstan are not doing much better, but most other post-Soviet countries seem better off.

An instant suspicion is that Ukrainian statistics are too poor to register actual growth. It is true that Ukraine?s GDP is understated in official statistics, and Ukraine has done less than, for instance, Russia to improve its statistics and measure the unregistered economy. Moreover, the underground economy is undoubtedly large in Ukraine. Simon Johnson, Daniel Kaufmann and Andrei Shleifer (1997, p. 183) made an estimation of the underground economy in 11 post-Soviet countries. They found that in Ukraine the underground economy amounted to 49 percent of GDP in 1995. It was larger only in Georgia and Azerbaijan. Moreover, they observed a substantial expansion of the share of the underground economy every year, while it declined in successful reform countries, such as Poland. Still, even compensating for Ukraine?s large underground economy the country has experienced a substantial decline in output both in absolute and relative terms.

Although it took Ukraine several years to get inflation under control, by 1996 inflation fell to 40 percent a year, and it has stayed well below that level. In 1997, inflation was only 10 percent and it only doubled in the crisis year 1998. The stabilization policy was augured with a strict monetary policy, but the budget deficit has gradually been brought under control ? to 2.7 percent of GDP in 1998 and a deficit of only one percent of GDP is planned for 1999 (see table). The cause of the reduction in the budget deficit can be explained as a lack of financing. Ukraine lingered on the verge of default for most of 1998 and the first quarter of 1999, but it has been avoided although international reserves were as low as $600 million in March 1999 (ten days of imports). Still, Ukraine has proven that it has sufficient treasury controls to avoid default.

Privatization has been slow and the quality of privatization has been poor in the sense that it has not promoted new strong owners who endeavor serious enterprise restructuring. Land reform, with the introduction of private ownership of land, has been a persistent aim of the reformers, but the left in the parliament was too strong and committed to public ownership of land (Lerman, 1999). The parliament has intermittently tried to block all kinds of privatization, causing great problems for the government. As a result, enterprise life has been extremely stagnant. In 1996, the average tenure of an enterprise managers was ten years, and it was virtually impossible to remove a passive, incompetent or criminal enterprise manager. Many managers had run their companies down close to a stand-still, but they did not give up or sell off any assets. They only demanded more money from the government. The small-scale privatization was completed in 1996, and the large-scale privatization picked up speed. Yet, the parliament has effectively vetoed all land reform, and it has blocked thousands of enterprises from privatization, but it has not been the only guilty party. Few large enterprises have been offered in open sales, and the arcane practices of Ukrainian privatization have deterred foreign investors. In 1997, Poland attracted four times more foreign direct investment than the $2.5 billion Ukraine had accumulated during its whole period of independence (EBRD, 1998). The Ukrainian stock market has never taken off, as shareholders? rights have been ignored.

Ukraine's big problem is ubiquitous and arbitrary state intervention. Its deregulation was slow and remains incomplete. Foreign trade was only formally liberalized, and new regulations have been introduced repeatedly, all too obviously to generate more bribes for the foreign trade administration. The same is true of most of the government administration. There are too many government bodies; they are too centralized, and their coordination is minimal, while they allow themselves a great deal of discretion. An extraordinary chaos persists, which seems peculiar to Ukraine in its degree. Beneath this administrative disorder, a large number of government officials bother enterprises and enrich themselves in the process. The key public policy issue is to control the state apparatus to make it possible to run independent enterprises.

Ukraine ranks very low on all liberalization indices. The index of economic freedom of the Fraser Institute puts Ukraine as number 106 out of 114 countries (with Russia as number 102) [reference!]. The index of economic freedom of the Heritage Foundation ranks Ukraine as number 124 out of 161 countries (with Russia as number 106; Holmes, et al, 1999). However, on the corruption perception index of Transparency International (1998) Ukraine is number 69 out of 85 countries, while Russia is number 76, that is, more corrupt. In most these regards, Ukraine appears about as bad as Russia, and there are after all many countries in the world that are both. Bribes paid are clearly higher in Russia than in Ukraine. However, Ukraine tops one statistic, that is senior management time spent with officials (Statistics provided by Daniel Kaufmann at the World Bank). The problem in Ukraine is less that government extracts large bribes than that it often seems impossible to get anything done.

Initially after independence, the Ukrainian political establishment was completely preoccupied with nation-building for natural reasons. In several countries, notably in Estonia and Latvia, market economic reforms were seen as part and parcel of nation-building. In Ukraine, however, nation-building was widely perceived as separate from market economic reform, and many tendencies drove Ukraine in the wrong direction. Key reasons for Ukraine?s choice of economic course was its choice of leader, the understanding of nation-building, the framework of mind, and the nature of the political elite.

On December 1, 1991, the Ukrainians elected Leonid Kravchuk the first President. At the formation of a nation, the leader is of great significance. Kravchuk had been Second Secretary of the Communist Party of Ukraine, and he was one of the foremost representatives of the old communist establishment, even if he formally parted with the communists and stood up for Ukrainian independence. Kravchuk had been responsible for ideology within the Communist Party with no understanding of, or interest in, economics. Kravchuk was a man of consensus, and he was seen as a man who could mediate between the Russified Eastern Ukraine and the nationalistic Western Ukraine as well as between the communist establishment and liberals. His yearning for consensus prevented him from making a clear choice on economic strategy.

The primary concern of the newly-independent nation was the building of new national institutions. Although Kyiv had formally been the capital of the Socialist Soviet Republic of Ukraine, it was merely a provincial capital. Some national institutions existed in a rudimentary form, for instance, the Ministry for Foreign Affairs, while the Central Bank and Ministry for Foreign Economic Relations were missing altogether. For natural reasons, the newly-independent Ukraine was preoccupied with the establishment of its national symbols, and many Ukrainians wanted as strong national institutions as possible with large staff and extensive powers. Thus, it became a national virtue to build up bureaucracy and regulations, as long as they were national. The most disturbing example was that Ukraine recreated Soviet-type foreign trade regulations in an attempt to ensure that the Ukrainian state had control over the country?s foreign trade. The stage was set for the rule of a massive centralized bureaucracy.

These problems were interpreted within a peculiar frame of mind. Economics and social sciences had been very weak in Ukraine, because the Soviet authorities had always been particularly afraid of Ukrainian nationalism, making Ukraine subject too much more control and repression than Russia or the Baltics. As a consequence, Ukraine suffered from an especially great shortage of all nation-building skills. Incredibly, this country of 52 million citizens had only one economic journal, and that was totally dominated by old-style communists. As Ukraine had been rigorously isolated from the outside world, few people in Ukraine spoke English or other foreign languages, which complicated its opening to the West. Ukraine hardly had a critical mass of sufficiently well-educated economists for launching radical economic reforms. Under the Kravchuk administration, various ideas of a special Ukrainian economic model arose. They were not very original and can be described as a mixture of muddled Gorbachevian economic thoughts, that is, the last stage of communist confusion, and surviving statist nationalist economic thinking from the 1930s about the need for a strong regulating state.

Nor did the burning economic problems persuade the leading Ukrainians to move in the right direction. At the end of 1991, the most apparent economic crisis was massive shortages. Ukraine?s shops were virtually empty, because prices were kept regulated by the state at an artificially low level, while the central Soviet government issued uncontrolled amounts of credits. While it was obvious that prices would have to be freed, no leading Ukrainian politician was prepared to take the responsibility for the ensuing inflation. In the end, Ukrainian prices were liberalized to a considerable extent in January 1992, but it was done in agreement with Russia, which meant that Russia was to blame. The new Ukrainian government took no responsibility and it displayed no commitment to free prices or free trade.

The devastating financial crisis was another urgent concern. Even before prices were liberalized, Ukraine probably experienced a couple of hundred percent inflation in 1991, and after prices had been freed they rose by 2,730 percent in 1992. However, inflation was largely perceived as a problem arising from Russia. A prevalent idea was that Ukraine was rich and the problem was how to escape from Russia?s parasitism. Much of the early economic discussion in Ukraine focused on how to isolate Ukraine from Russia?s inflation and to establish an independent currency. As early as January 1992, Ukraine introduced its own coupon, which was a parallel Ukrainian currency to the old Soviet ruble, which continued to circulate. However, clear thinking about the management of a national currency was missing, and Ukraine ended up issuing even larger ruble credits than Russia in relation to its GDP, which in turn led to a Ukrainian inflation of 10,155 percent in 1993, when Russian inflation had fallen to 840 percent.

The fundamental problem, however, was that there was too much of a continuity in the Ukrainian establishment. The elite was weak, small and homogenous. The transformation of the Second Secretary of the CPU for ideology to the first President of Independent Ukraine was emblematic of this harmful continuity and lack of competition. The prime problem was perceived as excessive dependence on Russia, while the harm of inheriting of a communist system, though universally recognized, was not given sufficient attention. As Ukrainians were anxious to attain consensus around their new state, they were worried about too much competition. In effect, much of the old Soviet nomenklatura persisted in Ukraine, while changing their party cards for national insignia.

The stage was set for extraordinary rent-seeking. Radical reforms had been discarded as characteristic Russian rashness, incompatible with Ukrainian peacefulness and moderation. The old establishment largely stayed intact, and it wanted to transform its power into material benefits. A cumbersome bureaucracy and regulatory system were being built as a manifestation of the Ukrainian state. Soon enough, these conditions bred severe corruption and rent-seeking. As a natural result, in the winter of 1993/94, the Ukrainian government was dominated by a group of so-called red directors, enterprise managers from Eastern Ukraine who had joined the government to maximize their personal revenues, through cumbersome regulations allowing few but themselves to make money. They intentionally introduced laws and regulations that would generate corruption to their own benefit. The same was true of Pavlo Lazarenko?s tenure as Prime Minister 1996/97.

A mixture of state enterprise managers, new entrepreneurs, government officials, commodity traders, bankers and outright criminals thrived on incomes caused by government subsidies and regulations, that is, rent-seeking. There were four dominant forms of rent-seeking. The first was to buy metals and chemical in Ukraine, which were cheap because of price regulation and sell them abroad at the world market price. This required access to the metals and export permits. About 40 percent of Ukraine?s exports were commodities in 1992 (IMF, 1993, p. 113), and their average domestic price was about 10 percent of the world market price. Hence, the total export rents amounted to some $4.1 billion or 20 percent of GDP in 1992. The beneficiaries were managers of state metallurgical companies, commodity traders, foreign trade officials and some politicians. The second method was to import certain commodities, notably natural gas from Russia at a low subsidized exchange rate, and resell at a higher price. It was even more profitable if you did not pay for the deliveries but let the government pay on the basis of state guarantees for the gas imports. The main beneficiaries were a small number of gas importers and their government partners. The third way was subsidized credits. In 1993, Ukraine experienced 10,155 percent inflation, but huge state credits were issued at an interest of 20 percent a year, that is, state credits were sheer gifts, and they were given to a privileged few. In 1992, net credit expansion to enterprises was no less than 65 percent of GDP and 47 percent of GDP in 1993 (calculated from IMF, 1993, p. 109; IMF, 1995, pp. 73, 105). The fourth form of rents was straightforward budget subsidies, which amounted to 8.1 percent of GDP in 1992 and 10.8 percent of GDP in 1993 (IMF, 1995, p. 94). They were concentrated on agriculture and energy, that is, gas and coal industry, which became totally criminalized by a struggle over these subsidies (IMF, 1995, p. 94). In comparison with Russia, the export rents are lower, the import rents clearly much higher though not estimated here, the subsidized credit much larger and the direct enterprise subsidies about the same. In total, rents as a share of GDP were higher in Ukraine than in Russia in both 1992 and 1993 (Åslund, 1999). Much of these rents have been accumulated abroad in tax havens.

In this way, a small select group of privileged insiders usurped a huge share of GDP in the early years of transition and grew strong. They have no reason to abandon their enormous power and wealth. It is not based on property, but on arcane financial flows. For society, the result has been sharply rising income differentials. Ukraine has reached a Gini coefficient of 47, about as much as Russia or a Latin American average (Milanovic, 1998, p. 41). In addition, society has gone through hyperinflation, shortages of goods, sharply falling output, and general misery. By June 1996, macroeconomic stabilization was happily taking hold at long last, as monthly inflation reached zero, and the inflationary rents were largely abolished. However, the other forms of rents have been maintained. Ukraine?s dominant problem is that much of the initial rent-seeking has been preserved, and it harms economic development, as it is extracted through an over-regulation of the economy.

Ukraine stands out as one of the most clear-cut examples of gradual reform. It illustrates that the choice was not between an early sharp fall in output with radical reform and a protracted but less abrupt decline in production with gradual reform. Ukraine?s slow and moderate reforms have brought a lasting degeneration of the economy as a whole. It shows that gradual reforms take a country on a different development path, and gradual reform breeds economic interests that will work for rent-seeking rather than profit-seeking. Ukraine lacks a middle class of profit-seeking entrepreneurs. Therefore, no strong constituency for economic deregulation has been bred as yet. Ukraine?s future evolution is constrained by its unfortunate original path.

In order to understand Ukraine?s economic and political problems today, we need to identify the dominant financial-political interest groups. They tell us a lot about the structure of the economy, the real political forces, and the constraints on economic policy making. Like Russia, Ukraine has a well-developed oligarchic power structure, but the differences are as interesting as the similarities.

From a number of recent conversations with leading Ukrainian politicians, I have extracted that the main economic-political groups or clans in approximate order of current economic and political importance are the following. A caveat is that the scene changes fast. Igor Bakai, the head of a series of companies importing gas from Russia, and former Deputy Prime Minister for energy Anatoly Holubchenko form the most important group, which is closely connected with Kuchma. Bakai head the state company Ukrnaftagaz, which imports some 80 percent of all gas Russia sells to Ukraine. Vadim Rabinovich is Ukraine?s foremost media tycoon with one TV channel and perhaps a quarter of all newspapers. His partner is presidential advisor Aleksandr Volkov. The partners Grigory Surkis and Viktor Medvedchuk control the holding company Slavutich and trade around Kyiv. Surkis owns Dynamo, Kyiv, Ukraine?s best foot-ball team. Viktor Pinchuk from Dnepropetrovsk is a newcomer in the elite after his marriage to Kuchma?s daughter Elena. He is now assuming control over much of the trade and metallurgy in Dnepropetrovsk. A few groups have recently lost much of their clout. Most spectacularly, former Prime Minister Pavlo Lazarenko is applying for political asylum in the USA after having opposed Kuchma but gaining a minimum of public support. His business partner was Julia Timoshenko, CEO of United Energy Systems, which used to be Ukraine?s main gas importer in 1996 and 1997 and is also involved in oil and metal trade. Timoshenko has recently switched allegiance to Kuchma, but she is still cold-shouldered by the government. Father and son Anatoly and Igor Franchuk run the Crimea both politically and commercially. Father Anatoly Franchuk has repeatedly been Prime Minister of the Crimea and his son Igor runs Ukraine?s largest petrol company. However, they have lost clout after Kuchma?s daughter Elena divorced the younger Franchuk recently. Donetsk had a strong metallurgical and coal group led by the former governor Wolodymyr Shcherban, but he and many of his men were ousted by Lazarenko in July 1996, and they have not really recovered. Just before, in April, Donetsk?s main gas trader Oleg Grek was murdered. In Odessa, the former mayor Eduard Gurevits ran a tight trading organization, but he has been ousted as mayor and now lives in exile and his business group has been weakened. These groups differ from the Russian ones in several regards.

The Russian groups are usually led by one person, the head of a private enterprise group. The Ukrainian groups are often identified by two leaders, one senior government official and one enterprise leader, sometimes of a state enterprise. This shows that there is no real division between government and enterprise in Ukraine as yet, which has happened in Russia. This seems to be a merit of the Russian mass privatization.

2. Many of the leading Ukrainian businessmen are deputies, for instance, Timoshenko, Lazarenko, and Medvedchuk, while few leading Russian businessmen are. The Ukrainian Rada is evidently much more important for corrupt business than the Russian Duma is. Moreover, the Ukrainian businessmen seem to spend most their time hanging around parliament or government, while the Russian businessmen seem to spend more time on their actual enteprises.

3. The leading Ukrainian businessmen are usually commodity traders and outright racketeers. None of them is even a banker and none is a real producer, while a couple (Vadim Rabinovich and Pavlo Lazarenko) are also media tycoons. This reflects that the Ukrainian economy has got stuck at the first stage of transition and is hardly moving on in terms of deregulation, while the Russian economy is more deregulated. As late as fall 1998, Ukraine?s main gas importer, Igor Bakai, stated in a newspaper interview: "All rich people in Ukraine made their money on Russian gas" (Timoshenko, 1998). One of the most successful Ukrainian bankers, Serhyi Tyhypko, is effectively Chairman of Privatbank as well as Deputy Prime Minister for economic affairs, but bankers are no major political force in contrast to Russia.

4. Unlike the Russian groups, the Ukrainian economic-political groups are primarily regional, which appears a reflection of the importance of racketeering for their revenues. Yet, relations with the central government are much more important in Ukraine than in Russia.

5. Although the Russian financial-industrial groups are generally perceived as involved in criminal activities, they are not considered to represent outright organized crime. In Ukraine, however, there seems to be no line whatsoever between organized crime and the leading economic-political groups, most of which seem to see racketeering as one of their main activities.

6. In Russia, the financial-industrial groups provide financing to various parties and to the government. In Ukraine, the economic-political groups rather tend to own political parties. Lazarenko and Timoshenko created the parliamentary party Hromada, as a company party of the Unified Energy Systems. Vadim Rabinovich has reportedly "bought" the Green Party. Surkis and Medevedchuk reportedly own the United Social Democratic Party. However, Bakai, Pinchuk and the Franchuks support Kuchma directly and possibly his party the National-Democratic Party. Characteristically, all these oligarchic parties are considered centrist, that is, always prepared to make a deal without any real ideology.

7. The Russian financial-industrial groups have been engaged in vicious and open competition with one another since July 1997. They are sometimes completely opposed to the government but survive. In the elections in March 1998, both Hromada and the United Social Democrats opposed president Kuchma and the government. As a consequnece, Lazarenko was forced into exile, while Timoshenko, Surkis and Medvedchuk switched to Kuchma. Currently, none of these groups dare to oppose the government or the president openly, which underlines how dependent they are on the government.

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About the Russia and Eurasia Program

The Carnegie Russia and Eurasia Program has, since the end of the Cold War, led the field of Eurasian security, including strategic nuclear weapons and nonproliferation, development, economic and social issues, governance, and the rule of law.